ETFs: It’s One Thing to Not Know, It’s Another to Be Told What Isn’t So

Essential value of an index is that it is a passive form of investing, the opposite of active management

Active manager’s results are dependent upon security selection

Indexation’s foundational intent is that the results will derive from broad exposure to a vast array of securities – no individual security will dramatically impact the result

PowerShares NASDAQ 100 ETF (QQQ) has almost $50Bn of assets, making it one of the country’s 10 largest

Top 5 holdings in the NASDAQ 100, which are Apple, Google, Microsoft, Amazon, and Facebook, total 41% of the value of the entire index

Clearly, this index is the opposite of diversified – its results depend powerfully on individual securities

According to the QQQ fact sheet, P/E ratio of the NASDAQ 100 is 22.2x, calculated on a trailing basis, and that is roughly comparable to the P/E of the S&P 500

QQQ P/E is not the simple mathematical average of the P/E ratios as one might naturally expect

First, it is calculated by excluding all firms with negative earnings – also effectively excludes companies with excessively high P/E ratios

In reality, one knows that an unprofitable company makes an investment more expensive, while in the world of indexation (such as in the QQ), unprofitable companies are eliminated, making the P/E lower

A footnote on the fact sheet indicates that the P/E is calculated using the Weighted Harmonic Mean

Translating this into the 3-step recipe via which an egregiously high P/E ratio is cleansed into a harmless middling sort of group average (Example based on hypothetical equal-weighted 4-stock portfolio – Stock A: 10x; Stock B: 20x; Stock C: 30x; Stock D: 300x)

First step is to calculate the reciprocals of each P/E ratio (i.e. 10 is turned into 1/10 or 0.1 and 300 is turned into 1/300 or 0.003). This is done for each company and those reciprocals will be added up

Steps 2 and 3 involve taking an average of the reciprocals just summed and then taking the reciprocal of that number

That completes the strange journey of transforming a fairly understandable, if alarming, P/E of 90x into the more comforting Harmonic Mean P/E ratio of only 21.5x

A more representative and straightforward way of calculating the index P/E ratio would be to simply divide its market cap by the total GAAP net profit that all those companies produce

Measuring the NASDAQ 100 valuation in a manner more aligned with accepted procedure, by calculating the simple average of the P/E ratios of the 91 profitable companies, results in a valuation of 43.6x earnings

No active manager would be permitted to manage a concentrated, high P/E portfolio for an institutional client – only an index enjoys this privilege

Can One Hide From The NASDAQ 100 In The S&P 500?

The NASDAQ 100 is a convenient way to observe some stark, un-indexlike distortions within a major index, distortions neither known to or expected by the typical index buyer, nor printed on the label – same issues impact the S&P 500 index, if perhaps less obviously

Amazon is now 1.85% of the S&P 500 – having appreciated by 29.1% in 2017 thus far, has produced 45 bps of the entire index’s YTD return which (as of 6/30) is about 9.3%

Facebook is 1.72% of the index and has appreciated by 31.2%, producing 44 bps of the YTD return of the S&P 500

If competing against the index, merely misjudging 2 securities in terms of return potential, one is automatically at a return disadvantage of 99 bps or more

Add to those Apple, Microsoft, Google, and those 5 stocks are responsible for 243 bps of the S&P 500 return thus far in 2017, or 26% of the total

Worded differently, a manager/analyst who was so brilliant as to have a stock selection error ratio of merely 1%, by not owning these 5 of the 500 stocks, would have underperformed by more than a quarter of the S&P 500 return – this is a degree of narrowness that is very un-indexlike

In 2015, the 10 best performing stocks in the S&P 500, 2% of the holdings, accounted for more than 100% of the return that year (Amazon, Microsoft, Google, Facebook, and Netflix)

In 2016, 5% of the S&P 500 companies accounted for 50% of the index return (failure to own those 25-odd names, and a manager would have underperformed by nearly 600 bps)

Right on Schedule: Google + Facebook Versus AOL, 18 Years and Counting

Facebook and Google (or Alphabet) are likely to generate $35Bn and $105Bn of revenue in 2017, respectively

Global advertising expenditure is unquestionably cyclical – assuming no recession in 2017, perhaps $602Bn will be spent in 2017 for advertising. Facebook and Alphabet alone should generate at least $140Bn of revenue (23.2% of worldwide advertising expenditure)

Assuming Facebook and Google grow by 25% per annum, they should collectively generate $273Bn by 2020

If we assume 4% per annum growth in worldwide advertising expenditure, total sum should equal $677Bn in 2020 – in which case, Google and Facebook should control 40% of the world’s advertising expenditures in 2020

This is a plausible figure and one that is reflected in these companies’ high P/E ratios

Eventually, the P/E ratios accorded to their shares will come to reflect the cyclicality of the industry – the problem is that no one can predict what their maximum market share % will be

Imponderables are: 1) maximum share of advertising revenue these firms can achieve; 2) time at which the maximum share will be reached; 3) P/E at the time that Google and Facebook absolutely dominate advertising; 4) whether there will be a cyclical decline in advertising expenditure that will disrupt the growth of these firms

Ultimately, the situation for an investor today is that of 2 cyclical firms that appear now and will continue to appear to be growth companies until they achieve true dominance of the industry – a position they are almost on the verge of achieving – and then there is likely to be valuation multiple compression

When will the market realize that? It is a very dangerous game to play

AOL, once the largest-market cap company in the world at $222Bn in December 1999 – even today, 18 years later, only 13 companies have a greater market cap

In January 2000, within a few inches of the tech bubble peak, AOL and Time Warner agreed to merge (one of the greatest cases of buyer’s regret in stock market history)

90% of a $350Bn combined stock market cap dropped at the time of the merger